Shadow inventory.

Those simple words stand for something that can have a big impact on the housing market. You’ve probably heard the term used by economists and real estate professionals, but what exactly is shadow inventory and what does it mean for your local market?

The definition of shadow inventory can vary depending on whom you ask, says Steve Harney, a housing industry consultant and founder of Keeping Current Matters. Harney writes about the impact of shadow inventory in the real estate blog, The KCM Blog.

“There is so much confusion with shadow inventory,” he said.

Banks sometimes define it so narrowly as to include only the real estate-owned (REO) properties currently on their books while others want to stretch it to include all of the non-distressed sellers who are sitting on the sidelines waiting for the market to turn.

But the more generally agreed upon definition used by the National Association of REALTORS®, CoreLogic, Standard and Poor’s and others covers three specific segments of the distressed market. They are:

Homes where the owners are at least 90 days delinquent on mortgage payments.

Homes in the foreclosure process.

REO homes now owned by the bank but which have not yet been listed for sale.

This “shadow” of distressed properties are those that are headed for foreclosure and will eventually be going into the market at reduced prices, putting downward pressure on overall home prices.

Impact on consumer demand

Harney says the impact of shadow inventory on prices is two-fold. Buyers hear of the possibility of newly discounted inventory and it can decrease the demand for non-distressed properties. Second, shadow inventory also affects appraisals because once a certain percentage of a market is distressed, the banks may require appraisers to use those as comparables.

“As long as there is shadow inventory, as long as there is a dripping inventory of discounted properties, it will take some of the (consumer) demand away,” he said.

How big is the shadow inventory? Estimates can vary by state and depending on who is calculating the estimate. CoreLogic puts the total around 1.5 million units while the National Association of REALTORS® (NAR) in February estimated it at 2.1 million, down from 2.5 million two years prior. NAR Chief Economist Lawrence Yun (citing July data from the Mortgage Bankers Association) said delinquencies are also falling.

Better news ahead

What is important to know is that many experts agree that the shadow inventory is declining nationally.

CoreLogic announced that the U.S. residential shadow inventory fell this spring to 2008 levels. And in its August MarketPulse report, CoreLogic Chief Economist Mark Fleming wrote that the U.S. shadow inventory is improving with new “serious delinquency starts” falling.

“Home prices are responding positively to reductions in both visible and shadow inventory over the past year,” Fleming said in August. “ This trend is a bright spot because the decline in shadow inventory translates to fewer distressed sales, which helps sustain price appreciation.”

NAR’s Yun has said shadow inventory is still a market factor, but levels have dropped over the past two years. And while Standard and Poor’s estimates that it would take 46 months to clear the U.S. residential shadow inventory, analysts there have said the rate of properties going into shadow inventory is slowing.

Why the shift?

One factor is that banks are now more willing to consider mortgage modifications or short sales, which can keep homes from going into foreclosure in the first place. At the same time, buyer demand is up while traditional inventory is low, all good signs for a recovering market, Harney said.

Another factor is that more states are clearing the backlog of foreclosures that built up while the national mortgage settlement was being settled. Many states with high foreclosure levels – California, Arizona and Nevada – are moving through their inventories. It is taking longer to clear inventory in Illinois and other states where foreclosures must go through the courts, Harney said.

Looking at the Chicago area and the current rate of foreclosure sales, it will take about 3.2 years to clear through the foreclosure inventory and another 1.1 years for the distressed homes that may go into foreclosure, said Dr. Geoffrey J.D. Hewings, Director of the Regional Economics Applications Laboratory of the University of Illinois.

Hewings cautions it is important to remember that even in booming housing markets, there are always homes in foreclosure.

“If you go back in history there were always foreclosed properties on the market. Clearing the market of all foreclosures never happened in the past, so we should have no expectation that it’s going to happen in the future,” he said.

What can REALTORS® do?

First, don’t be afraid of it, Harney says. “Realize it’s just inventory coming to the market like any other and let’s clear it as quickly as we can.” Harney says there is no such thing as bad news in the real estate industry. If prices are low, that is good news to buyers and bad news to sellers, but the reverse is true when prices climb.

Second, educate yourself about shadow inventory so that you will be able to talk knowledgeably to your clients about how it will affect the pricing of their homes. Shadow inventory comes down to a question of supply and demand, Harney said. When home prices ran up before 2006, it was because demand outpaced supply. Now there is not only an increase in supply but also distressed supply.

Third, remind your sellers that despite the shadow inventory, they must look at their situation and determine if it is better to sell their homes now rather than wait, Harney said. Prices will go up and sellers who wait could end up paying more for the home they want to buy.

Shadow Inventory Making your sellers skittish?

Real estate coaches Rich Levin and Bob Corcoran offer these scripts to use with your clients encouraging them to sell.

#1: Testing the market

“Every person selling wants to test the market with a higher price to see if they can get more. With all the activity right now that might make sense. But there is a danger. There is good pressure right now pushing prices a bit higher because there are more buyers for some price ranges than houses for sale. That could change pretty quickly. The banks are waiting to foreclose on a lot of property. When the government reduces the regulations and those properties come on the market it is likely that this will quickly turn back into a buyer’s market pushing prices downward again. So, I’d suggest we put it on the market at or close to the price I’m recommending. If you do want to start with a higher price, I’ll work hard to get you whatever price you choose. If we start higher than I recommend and the house isn’t sold, we reduce the price in two or three weeks. Do you want to put it on the market at the recommended price or something higher or lower than that?”

-Rich Levin, master coach and speaker, Rich Levin’s Success Corps

#2: Today’s Market advantage

“Mr. Seller, now is the time to get your home on the market. With inventories getting tighter and the interest rate at an all-time low we have serious buyers looking for homes right now, okay? (Wait, listen and acknowledge the response.) Great!!! As you may have heard we will soon be seeing bank owned properties coming back into our market, and you do remember what happened to housing prices just about a year ago when that happen, right? (Wait, listen and acknowledge the response.). So, in order to take advantage of today’s market and the serious buyers that want to purchase now at a fair price, we need to get your home on the market right away, that makes sense doesn’t it? (Wait, listen and acknowledge the response.) Great, so what works better for you to get together mornings or afternoons?”

- Bob Corcoran, founder and CEO of Corcoran Consulting and Coaching

Breakout Text:

“What we need to do as an industry is not be afraid of shadow inventory. Realize it’s just inventory coming to the market like any other and let’s clear it as quickly as we can.” - Steve Harney

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